Clemente De Lucia, BNP Paribas, Paris.

Key Concepts: Inflation | Monetary Policy |

The Tightening Cycle will Proceed…

At its June meeting the European Central Bank (ECB) Governing Council left
its key policy rate unchanged, signalling, however, that an interest rate
hike within one month was likely. The code word “strong vigilance”
– which in the past had signalled a rate hike within one month –
was included in the communiqué following the two-day meeting. It
looks likely therefore that the refinancing (refi) rate will be raised to
1.5% in July.

The tightening cycle looks set to continue. President Trichet stressed
that risks to price stability are on the upside. The ECB has revised upward
its inflation projections for this year and left them almost unchanged for
2012. Admittedly inflation eased in May (to 2.7% from 2.8%, see Chart 1),
but this looks unlikely to be anything more than a pause in a rising trend.
After being distorted in April by the late timing of Easter, core inflation
probably eased in May, but is also likely to start trending higher, albeit
at a moderate pace, over the coming months. Firms continue to pass on past
price increases in commodities to final prices. Alternative measures of
underlying price pressures, such as the trimmed mean, which excludes the
most and least volatile components from the harmonised index of consumer
prices (HICP) each month and in the past has proved to be a good leading
indicator of the traditional measures of core inflation, are on the rise.
Lastly, ongoing growth in global activity – albeit at somewhat slower
pace – will continue to keep oil prices at fairly high levels. Headline
inflation will therefore rise over the coming months and could exceed 3%
by year-end, before easing next year.

Other indicators confirm the build-up in price pressures. The output gap
– the difference between current output and the level of production
that can be achieved using available production factors without generating
inflationary pressures, or potential output – is still negative, but
it is closing, pointing to rising price pressures (Chart 2).

It is, however, worth noting that there are two reasons for the narrowing
of the gap. First, it is true that the recovery in the eurozone has strengthened,
particularly in the first quarter of the year. GDP growth accelerated to
0.8% (quarter-on-quarter) in Q1 2011 from 0.3% in the previous quarter,
sustained by a sharp rebound in investment and by exports, while private
consumption, constrained by still tough labour market conditions and the
fiscal consolidation measures adopted in several eurozone countries, progressed
at a much slower pace. The ECB has also revised upwards its growth forecasts
for this year.

Secondly, however, it seems also likely that potential output has decreased
as the disruption from the financial crisis has probably reduced the stock
of capital and increased the structural rate of unemployment. The European
Commission and the ECB are forecasting a potential GDP growth rate for the
eurozone of between 1-1.2%, compared with close to 2% before the crisis.

Chart 1: Headline and Core Inflation

Chart 2: Underlying Measures of Price Pressures and
the Output Gap

...But at Moderate Pace

The picture for the eurozone as a whole masks deep differences between
countries. Core countries, especially Germany, are doing pretty well. Activity
in Germany has even come back to its pre-crisis level. However, conditions
in peripheral countries are extremely different, with activity either showing
very low growth or even contracting. Internal divergences within the zone
are a problem for setting a common monetary policy and will remain so. The
ECB will continue to set interest rates for the eurozone as a whole as it
has done in the past. The Bank would place itself in a very difficult position
if it were to be perceived to be setting interest rates with a view to economic
conditions in a particular country or group of countries rather than for
the region as a whole.

This said, internal divergences will probably affect at least two aspects
of ECB monetary policy: the pace of monetary tightening and the exiting
of non-conventional lending measures.

As regards the first point, it is likely that the ECB will continue to
raise rates every three months, while in the previous tightening cycle,
the Bank raised rates every two months (at least for a part of the cycle).
An interest rate hike is likely to be more damaging for peripheral countries
than for core countries. Spain and Portugal, for instance are among the
countries with the most negative exposure to the ECB’s monetary tightening
cycle, since almost all their mortgages have variable rates and are indexed
to Euribor. As shown in Chart 3, disposable household income in Spain is
much more sensitive to changes in Euribor interest rates than the eurozone
average.

Chart 3: Relationship Between Disposable Income and
Euribor

Chart 4: Yields on 2 Year Government Bonds and the
Refi

Although Tensions in Sovereign Debt Markets Persist, the Securities and
Market Program (SMP) has Probably Ended

The interest rate monetary transmission channel is not working properly
at present. Under normal conditions, monetary interest rate changes are
transmitted along the yield curve, affecting the financing costs of firms
and households. Higher policy rates would lead to higher government and
corporate bond yields and to higher mortgage rates and interest rates. Prior
to the financial crisis there was fairly strong correlation between all
countries’ 2-year rates (where credit risks do not play a crucial
role), and the policy rate. As shown in Chart 4, the correlation between
yields on 2-year German and French government bonds and the refi rate remains
strong. However, this is no longer true for those countries more affected
by the sovereign debt crisis (see Chart 5). Funding costs for these economies
are therefore much higher, as markets are extremely nervous regarding their
fiscal positions. Conditions are also tougher for Italy and Spain (see again
Chart 4).

In May 2010, when tensions in the sovereign debt markets intensified and
the ECB launched its Securities and Market Program (SMP), interest rates
on sovereign debt issues were below current levels. This would suggest that
the SMP should be further increased. However, the ECB has de facto stopped
the program at around €75bn. The last time that the Bank intervened
in the market was at the end of March 2011. In this way the ECB is increasing
pressure on governments to find a solution to the debt crisis by sending
a clear message that they cannot count on the ECB to solve fiscal issues,
something that could damage its credibility and independence. To some extent
this is bearing fruit. EU leaders are coming closer to an agreement regarding
additional funding for Greece, which will help to cover its funding needs
until mid-2014. Given that there are divisions at the ECB Governing Council
as regards the SMP, it is extremely unlikely that it will be expanded further.

Chart 5: Yields on 2 Year Government Bonds and the
Refi

Chart 6: Banking Lending Rates (to NFCs Up to 1 Year)
and Refi Rate

Further Withdrawal of Non-Standard Lending Measures has been Postponed

The ECB will continue to support the peripheral economies through its non-standard
lending measures. At its June meeting the Bank decided to continue to conduct
all its refinancing operations with full allotment at least until the end
of September. The ECB is currently allotting more than 60% of its liquidity
to Greece, Portugal, Spain and Ireland, whereas these economies amount to
only 16% of the eurozone GDP. Portuguese, Greek, Irish and to a lesser extent
Spanish, banks are still highly addicted to ECB liquidity, which suggests
that they have problems in finding liquidity in the money market. Funding
difficulties for the banking sectors are transmitted to the rest of the
economy to some degree. Chart 6 shows the bank lending interest rates to
non-financial corporations (NFCs – up to 1 year and up to €1
million) for some peripheral countries and for the eurozone as a whole.
The common picture is that bank lending rates did not decline as much as
the fall of the refi rate would have suggested (this was one reason why
the ECB adopted non-standard lending measures during the crisis). Bank lending
rates for the eurozone started to increase only moderately after the ECB
announced in March 2011 that it intended to raise rates. However, this was
not the case in peripheral countries where banking rates began to increase
earlier and at a faster pace (again see Chart 6), meaning that funding costs
for these economies rose faster than the policy rate would have suggested.

Chart 7: Euro zone-US 2 Years Yield Spread and Exchange
Rates

All in all, the ECB will continue its tightening cycle. Inflation is on
the rise and the Bank will use its standard policy instruments (that are
key rates), to maintain inflation in line with its objective of price stability
in the medium term. In addition, the Council fears that leaving interest
rates at low levels for too long could create financial distortions, favouring
further imbalances. Nevertheless, the ECB decided to keep its non-standard
lending measures in place, as some segments of the money market are not
working perfectly. The ECB is also the guarantor of the smooth functioning
of payment systems as stated in the Treaty (art. 105), and, as Mr Trichet
has said more than once, “whatever the interest rate, the money market
has to function”. An unbalanced recovery and persistent tensions in
financial markets will induce the ECB to proceed in its tightening cycle
at a modest pace. Apart from anything else, the strong euro has the effect
of tightening monetary and financial conditions, reducing the need for higher
rates. Different monetary policy orientations on both sides of the Atlantic
are widening the yield spread between the US and the eurozone, strengthening
the euro (see Chart 7). The euro is likely to remain at elevated levels
for a while (the OECD estimate of fair value is around 1.25, based on PPP
for GDP), before easing next year when the US Federal Reserve is expected
to start its own tightening cycle.